Trading the Opening Range: Mean Reversion vs Trend Following

The opening range trade is popular amongst active traders. Historically, the opening range was the first hour of the day. Recent market volatility has been crazy. Swings from all-time highs to correction territory and massive intraday moves have been difficult to navigate. Is there a roadmap for navigating the opening range? Is it trend following or mean reversion?

Trend following tries to capture price momentum. The trend is the general direction of price movement. A trend can be up, down, or neutral. 

Mean reversion trading fades momentum in the market. This type of trading looks for opportunities to buy when prices are below the average and sell when prices are above the average.

We tracked SPY’s trading range at 15-minute intervals from April 25, 2022, through October 24, 2022, to see what patterns emerged in the opening range during this volatile time.

The opening range trade

Figure 1 shows SPY’s average trading range for each 15-minute period of the trading day.

Somewhat as expected, the first hour of the day had the largest range. That’s why it’s the focus of so many traders.

We then divided the first hour of each trading day into four, equal-sized groups. Group 1 included days with the smallest-sized opening ranges, while Group 4 had the largest.

• Group 1: $0.00 - $0.22
• Group 2: $0.23 - $0.62
• Group 3: $0.62 - $1.02
• Group 4: More than $1.02

The trading range is defined as the difference from SPY's opening price at 9:30am EST and its price at 10:30am EST. For example, if SPY opened at $377.71 and its price at 10:30 is $376.85, the range is $0.86 (Group 3).

This will help us understand if the size of SPY’s opening range impacted that day’s price action.

Opening range trading signals

Now that we’ve divided the opening range into groups, we’ll consider the opening range direction. This let us test trend-following versus mean-reversion based on the first hour’s direction to see if there’s a tradeable edge for the rest of the day.

Figure 2 shows days where SPY had a negative opening range (i.e., SPY’s price was lower at 10:30 AM than at the market open), and Figure 3 shows days where SPY had a positive opening range.

The last blue bar in Figure 2 shows that 76% of Group 4’s days closed below the 10:30 AM price. So, over 3/4ths of days when SPY had the largest opening range in the first hour, its price continued lower into the close. This points to trend-following large opening range moves.

That tells us that when SPY’s price at 10:30AM was at least $1.02 lower than its opening price, 76% of the time SPY closed lower than the 10:30AM price. For example, assume SPY opened at $383.20. If at 10:30AM the SPY was trading below $382.18, 76% of the time its closing price was below $382.18.

We saw a similar pattern in Group 1 days, with 55% closing below the 10:30 AM price. This also points to trend-following small opening range moves.

The groups in the middle were the best candidates for mean reversion. Groups 2 and 3 had a 67% and 62% probability of mean reversion during the remainder of the trading day. This meant those mid-sized opening moves lower reversed and closed higher by the end of the day.

Small and large moves were more likely to follow the trend, while Group 2 and Group 3 opening ranges were prone to mean reversion. 

We saw similar data when SPY was up in the first hour. Instead of mean-reversion signals, we found more trend-following evidence, especially pronounced for small, first-hour positive moves (Group 1).

85% of small opening range moves ended the day higher and had an average return of +0.65% from 10:30AM to the market close.

Where do we go with this research?

The VIX has been the main way traders have filtered for 0DTE options strategies (iron condor versus iron butterfly). Iron condors in higher-vol environments and iron butterflies in lower-vol environments. What about filtering by opening range size? 

For example, take the days most likely to trend follow and open 0DTE call or put credit spreads OR iron condors. Take the days most likely to mean revert and trade iron butterflies or iron condors. 

The VIX is a 30-day estimation of volatility: does it make sense to use it for 1-day trades? Intuitively, it makes sense. It’s a barometer for volatility. However, taking the opening range move may make more sense. On top of that, you could add additional filters depending on the size of the move from the previous close. Alas, that’s a topic for another day.